Evaluating Solar Deals
In my previous blog, I discussed the basic structure of tax equity financing for solar projects. You may recall that a tax equity deal is a partnership between two stakeholders: a tax equity investor and a developer. The investor provides a large portion of the upfront capital needed to build the project for which it receives the majority of the tax credits from the project plus depreciation benefits and some cash. The developer usually installs and maintains all aspects of the solar project for which it receives the balance of tax credits, depreciation benefits, and a majority of the cash. This blog will focus on the management and evaluation of tax equity investments as part of a portfolio.
How does a tax equity investor evaluate an investment?
The goal of managing a traditional investment portfolio seems pretty straight forward. In most cases, the investor is trying to maximize his total portfolio after-tax returns. The problem with that statement is that the word “returns” can have many different meanings and can be measured in many different ways. If the real goal of the investor is to create as much value as possible for himself, then which of the many traditional financial metrics should he use to guide his decision making? Should he seek to maximize Total Returns? Return on Investment (ROI)? Internal Rate of Return (IRR)?
The table below shows three hypothetical scenarios of cash flows from tax equity deals from the point of view of a tax equity investor. The first quarter of each scenario shows a large negative amount – the investment capital. The subsequent quarters each show the resulting returns from that investment. Of note, because of the nature of tax equity deals, a large portion of the investment return occurs at the beginning of the investment period (in the form of the investment tax credits), shown in this example in January, 2015.
Cash Flows
What’s wrong with IRR?
Most sophisticated investors would use a financial metric which accounts for the time value of money, such as Internal Rate of Return (IRR), to evaluate investments. In this case, that would lead the investor to rank Scenario 2 the highest. So what’s wrong with that? To understand why Scenario 2 is not the best investment, you have to understand something about the details of the IRR calculation.
IRR is really a calculation that determines the discount rate that would make the net present value (NPV) of cash flows from a project equal to zero. This metric is useful to traditional investors where the investor in question has the ability to consistently reinvest his earnings into other similar investments once his returns are realized. For tax equity deals, however, the investor does not have that ability. This is because unlike traditional investment capital, tax liability in any given year is a limited commodity that is not replenished by returns from an investment. Since a company’s tax liability is limited, its ability to reinvest its returns in other tax equity deals is similarly limited. Therefore, a company will not necessarily create the maximum value for itself by investing in the projects with the highest IRR. Furthermore, a company may inadvertently negotiate inferior terms for a deal in pursuit of a higher IRR. In the case above, Scenario 2 has returns that are heavily front-loaded, making the IRR higher than the other scenarios. An unwitting investor may negotiate to achieve the cash flows of Scenario 2 to maximize the project IRR, leaving significant value on the table.
What’s wrong with ROI?
Because of the problems associated with IRR when evaluating tax equity returns, should investors use return on investment (ROI) instead? The obvious problem with the ROI calculation is how it treats the time value of money. Finance geeks will understand what that means, but for everyone else it simply means a dollar today is worth more than a dollar tomorrow. ROI does not recognize that fact and simply evaluates the total returns of a project in relation to the total upfront costs. When looking at the projects above, an investor trying to maximize ROI would choose Scenario 3. Similar to the previous scenario, this investor would also be leaving significant value on the negotiating table. (Hint: Of the options listed, I would argue that Scenario 1 provides the best returns.)
The possibility of new metrics
In practice, many tax equity investors use a combination of these and other traditional financial metrics. Unfortunately, all of these metrics fail to adequately capture the economics of a tax equity deal.
Because of its limited nature, the market will bear returns on tax equity that are significantly higher than returns on cash with a similar risk profile. Tax liability, therefore, should be considered separately and at a premium for investment purposes compared with cash. To evaluate solar tax equity deals, investors need to consider creating a new class of financial metrics that discount tax credits separately from cash flows. By creating new metrics that recognize the unique nature of tax equity deals, investors will be better able to identify the best possible deals and negotiate toward optimal portfolio performance.